What is depreciation? Definition, methods and examples

Published Thursday 2 April 2026

Table of contents

• What is depreciation?
• Depreciation examples
• Purpose of depreciation: three main functions
• What can be depreciated?
• Methods of calculating depreciation
• How to record depreciation in your books
• Simplify depreciation with Xero
• FAQs on depreciation

Key takeaways

• Record depreciation as a business expense on your profit and loss statement to accurately calculate your true costs and understand real profitability, since assets that wear down need eventual replacement.
• Use depreciation deductions to reduce your tax bill by gradually claiming the entire value of qualifying fixed assets like equipment, vehicles, and computers over their useful life.
• Choose the straight line depreciation method for most small business assets, which spreads costs evenly across the asset's useful life and works well for items like office furniture that provide consistent value.
• Set up your depreciable assets in accounting software with purchase price, useful life, and depreciation method to automate calculations and ensure accurate financial reporting throughout the year.

What is depreciation?

Depreciation is the gradual loss of value in a tangible business asset over time. It's an accounting principle formally defined by international standards.

A work computer, for example, depreciates from its original purchase price as it moves through its productive life. This process is governed by standards like IAS 16 for Property, Plant and Equipment.

Accounting techniques measure this declining value and record it in your books. A professional can help you navigate this area effectively.

Depreciation examples

Seeing depreciation in action makes the concept easier to understand. Here are three common small business scenarios:

• Work vehicle: You buy a delivery van for $30,000 with an expected useful life of five years. Using straight line depreciation, the van loses $6,000 in value each year. After three years, its book value is $12,000.
• Office computer: You purchase a laptop for $1,500 with a three-year useful life. It depreciates by $500 each year, reaching $0 at the end of year three.
• Restaurant equipment: You buy a commercial oven for $10,000 with a ten-year lifespan. Using straight line depreciation, it loses $1,000 in value annually. After five years, its book value is $5,000.

Purpose of depreciation: three main functions

Depreciation serves three main purposes in your business finances. It helps you understand the true cost of doing business, potentially reduce your tax bill, and estimate the value of your business.

One: Depreciation as an expense (cost of doing business)

To understand how profitable your business is, you need to know all your costs. Depreciation is one of those costs because assets that wear down eventually need to be replaced.

Depreciation accounting helps you figure out how much value your assets lost during the year. That number needs to be listed on your profit and loss statement and subtracted from your revenue when calculating profit.

Accounting for depreciation helps you accurately estimate your costs and understand your true profit.

Download a free P&L template to help you work out all your costs.

Two: Depreciation and tax

Depreciation can reduce your tax bill. Accounting for depreciation can help you pay only the tax you owe. You may be able to gradually claim the entire value of an asset as a tax deduction.

However, there are rules around how quickly you can depreciate certain assets from a tax perspective. Check with your tax office or accountant.

Three: Valuing your business (depreciation on the balance sheet)

As assets lose value, so can your business. A transport company with old trucks may be worth less than one with new trucks, for example.

You list your assets on your balance sheet in what's called the fixed asset register. Make sure you update the register whenever you calculate depreciation.

You can often use assets to secure loans. Maintaining asset values helps them offer stronger security, making it easier to get finance.

Download a free balance sheet template to help you track your assets.

What can be depreciated?

Not all business expenses can be depreciated. While most expenses are tax-deductible, depreciation works differently.

You can deduct consumables like stationery from tax, but you have to claim them in the year you bought them. For most businesses, only fixed assets can be depreciated.

What are fixed assets?

A fixed asset is something that helps you generate income for more than a year. Common examples include:

• tools and machinery
• computers and office furniture
• vehicles
• buildings

You don't always have to own them. You may be able to depreciate some leased items too.

Intangible assets like patents and copyrights can also be depreciated (or amortised). This practice is governed by standards like IAS 38 Intangible Assets. They're valuable to your business, and that value gradually shrinks as they near their expiry.

Assets that hold their value, such as land, are excluded from depreciation. You handle inventory separately under inventory accounting.

Methods of calculating depreciation

Before you calculate depreciation, you need to determine two things: the asset's useful life and the calculation method you'll use.

Useful life is how long the asset will generate income for your business. A computer might last three years, while a factory kiln could last 30. The tax office typically has depreciation schedules for common asset types, and most small business owners follow those recommendations.

You can adjust an asset's value to zero at any time if you lose it, someone steals it, or it gets damaged. You can also sell, trade, or combine it into a new asset.

Depreciation methods determine how an asset's value declines over its lifespan. Choosing an appropriate method is key for compliance. Some assets lose value evenly each year, while others lose more value early on. However, international accounting standards prohibit the use of revenue-based methods. Here are three common and acceptable methods:

Straight line depreciation

Straight line depreciation spreads the cost evenly across the asset's useful life. The asset loses the same amount of value each year until it reaches zero.

Formula: (Purchase price – salvage value) ÷ useful life = annual depreciation

For example, an asset worth $5,000 with a five-year lifespan depreciates by $1,000 each year. This method works well for assets that provide consistent value over time, like office furniture.

Diminishing value depreciation

Diminishing value depreciation applies a higher depreciation rate in the early years, with the rate gradually slowing over time. The asset loses more value upfront and less as it ages.

This method suits assets that lose value quickly after purchase, like vehicles or technology. It can also provide larger tax deductions in the early years of ownership.

Units of production depreciation

Units of production depreciation bases how value declines on actual usage rather than time. This method aligns well with accounting principles, which state that depreciation should reflect how you consume economic benefits embodied in an asset. This method works well when an asset's lifespan depends more on how much work it does than how old it is.

For example, a delivery vehicle might be depreciated based on kilometres driven, or a packaging machine based on units produced. This approach gives a more accurate picture of wear and tear for heavily used equipment.

How to record depreciation in your books

Recording depreciation keeps your financial statements accurate and your tax records up to date. Here's how to do it:

1. Set up your assets in accounting software. Enter each depreciable asset with its purchase price, useful life, and depreciation method.
2. Record depreciation expense. At the end of each period, record a depreciation expense that reduces your profit and an accumulated depreciation entry that reduces the asset's book value.
3. Update your financial statements. Depreciation expense appears on your profit and loss statement, while accumulated depreciation reduces asset values on your balance sheet.
4. Review at year end. Check that all assets are correctly depreciated before finalising your accounts and lodging your tax return.

Once you set up your assets, most accounting software, including Xero, automates these steps for you.

Simplify depreciation with Xero

Depreciation is straightforward once you understand the basics. Most businesses follow the depreciation schedule provided by the tax office, and accounting software handles the calculations automatically.

You can simplify depreciation with Xero. Once you set up your assets, you get automatic depreciation calculations that flow straight through to your financial reports and tax return. You get accurate cost tracking automatically.

With automatic depreciation calculations and tax-ready reports, you can focus on running your business. Get one month free when you try Xero today.

FAQs on depreciation

Here are answers to common questions about depreciation.

What's the difference between depreciation and amortisation?

Depreciation applies to tangible assets like equipment and vehicles, while amortisation applies to intangible assets like patents and copyrights. While the terms apply to different asset types, they're often discussed together. The published Amendments to IAS 16 and IAS 38 cover both because they spread the cost of an asset over its useful life.

Is depreciation an actual cash expense?

Depreciation is a non-cash expense. It reduces your profit on paper but doesn't affect your cash flow. You still need to track it because it reflects the true cost of using your assets.

What is a depreciation journal entry?

A depreciation journal entry debits depreciation expense and credits accumulated depreciation. This reduces your profit and lowers the book value of the asset. You can handle this automatically with accounting software like Xero.

What happens to depreciation when I sell an asset?

When you sell a depreciated asset, you compare the sale price to its book value. If you sell for more than book value, you record a gain. If you sell for less, you record a loss.

Do I need an accountant to handle depreciation?

It depends on your situation. Modern accounting software automates depreciation calculations and record-keeping. However, an accountant can help with complex situations, tax strategy, and ensuring compliance with local regulations.